21 May 2009, Peter Madigan, Risk magazine
The House Committee on Financial Services held a hearing yesterday on four draft legislative proposals designed to address distinct weaknesses in the US municipal finance market that have collectively wreaked havoc in the $2.6 trillion market.
The committee's first piece of legislation, the Municipal Bond Insurance Enhancement Act, would aid municipal issuers by providing federal reinsurance for municipal-only primary bond insurance, making it easier for smaller, lesser-known issuers to borrow by increasing the capacity of municipal bond insurers to insure new risks.
Problems in the US municipal market first appeared in the second half of 2007 as bond guarantors - otherwise known as monoline insurers - suffered large losses on insured structured credit products backed by subprime mortgages.
This led to the threat of credit ratings downgrades, which concerned money market funds exposed to the municipal market through securities called variable rate demand notes (VRDNs). These are short-term floating-rate notes that pay daily or weekly interest based on a money market rate such as one-month Libor, and which can be put back to a remarketing agent (typically an investment bank) with one or seven days' notice.
Money market funds are restricted by securities law to holding only AAA-rated paper, so the downgrades led to a wave of investors putting their VRDNs back to banks, swelling balance sheets already strained by emerging losses on securities backed by subprime mortgages. In late 2007 and early 2008 the expected rash of monoline downgrades materialised, severely limiting the ability of municipalities to wrap their debt, and limiting the investor base their bonds could be marketed to.
"The share of newly issued municipal bonds that are insured has fallen from about 50% in the [third quarter] of 2007 to about 10% in the first quarter of this year, and the market for reinsurance for such bonds is largely closed," said David Wilcox, deputy director of the division of research and statistics at the Federal Reserve, testifying before the committee yesterday.
By February 2008, banks' balance sheets finally reached the point where they were no longer in the position to buy back VRDNs or act as buyer of last resort in auctions for ARSs if no other bidder emerged. This left municipal authorities on the hook for heavy penalty payments to investors trapped holding the paper, to compensate them for the illiquidity of what was supposed to be a highly liquid short-term security.
The finance committee's second proposal - the Municipal Bond Liquidity Enhancement Act - would provide the Federal Reserve with the authority to fund new liquidity facilities for variable rate municipal bond securities such as VRDNs, in a bid to resuscitate the market.
With the Fed directly providing liquidity to the VRDN market, some public authorities currently grappling with brutally high interest rates, or unable to issue VRDNs into the market at all, may find relief.
"Many municipalities have reportedly succeeded in refinancing ARS into VRDNs or traditional fixed-rate debt, bringing down substantially the volume outstanding in the ARS market. One commonly used measure of the interest rates paid on high-quality VRDNs skyrocketed from less than 2% on September 10, 2008 to almost 8% in just two weeks. Since then, this measure has reversed its September spike and has fallen with other short-term rates to below 1%. Nonetheless, market participants report that the cost of liquidity support from banks has risen sharply," Wilcox testified.
Despite the stresses in the variable rate sector, the market for traditional fixed-rate municipal debt appears to be functioning fairly well for many issuers, Wilcox said, with gross issuance of long-term municipal bonds remaining fairly solid in recent months. Total gross issuance of long-term municipal bonds averaged about $30 billion per month during the first four months of 2009, in line with issuance during the first four months of both 2006 and 2007, before the crisis hit the municipal market.
While the first two measures offer government assistance to ailing municipal entities directly, the proposed Municipal Financial Advisors Regulation Act would regulate financial advisers to municipalities, which are not currently supervised under existing securities statutes, and make them register with the Securities Exchange Commission (SEC).
The municipal markets have long been dogged by allegations of "pay to play" activity - in which financial advisers on public bond issuances are selected on the basis of campaign contributions to the politicians behind the issuance - with allegations of such conduct recently scuppering the nomination of New Mexico governor Bill Richardson to the post of secretary of commerce in the Obama administration.
The most egregious example of pay to play behaviour in recent years, however, has been the case of Jefferson County, Alabama, which is facing the largest municipal bankruptcy in US history, provoked by the county's inability to repay $3.9 billion in sewer bond debt tied to interest rate swaps notionally valued at $6 billion.
The current mayor of Birmingham, Alabama, Larry Langford, was charged with 101 criminal counts in December, including bribery, money laundering, mail and wire fraud, pertaining to the award of bond issuance and swap servicing contracts to unregistered financial adviser Bill Blount.
As chair of the Jefferson County Commission between 2003 and 2006, Langford allegedly signed off on approximately $3.13 billion in new municipal bonds and warrants in the form of VRDNs and ARSs and authorised the County to engage in interest rate swaps worth approximately $5.3 billon with Wall Street counterparties to synthetically fix interest repayments. Roughly half those transactions faced JP Morgan as counterparty.
A Montgomery, Alabama-based broker, Blount Parrish, was named as underwriter, remarketer or adviser on both bond and swap transactions, allowing Blount to collect fees of approximately $7.1 million, while Langford allegedly received kickback in the form of cash and cheques worth $69,000, jewellery worth $235,000, $12,000 in audio equipment and tens of thousands of dollars in luxury clothing items. Langford's trial is expected to begin in June.
In its most recent 10-Q filing with the SEC, JP Morgan revealed that the securities regulator "had authorised the filing of an enforcement action against the firm alleging violations of federal securities laws and rules with respect to certain transactions executed in 2002 and 2003 with Jefferson County, Alabama. The firm has been engaged in discussions with SEC staff in an attempt to resolve the matter prior to litigation," the filing reads.
The financial services committee also proposes passing the Municipal Bond Fairness Act, which would seek to amend "the apparently unequal treatment" by ratings agencies of municipal and corporate bonds. The committee said analysis of the two consistently shows municipal bonds have lower credit ratings than corporate bonds with equal or higher default rates.
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